5-yr Treasury yields and inflation

It's always good to put things in perspective, so here's some long-term perspective on Treasury yields and inflation. I'm showcasing the 5-yr Treasury here, since the 5-yr maturity is very representative of the current Treasury market: the bulk of the $10.5 trillion of Treasury bills, notes and bonds held by the public mature within the next 10 years, and the average maturity of outstanding marketable Treasury debt is just over 5 years.

As the top chart shows, 5-yr Treasury yields today are at rock-bottom lows of only 0.7%, and they are very low relative to inflation. Over time, Treasury yields have a very strong tendency to track the level and the direction of inflation.

The bottom chart zooms in on the past 20 years and puts core inflation on a slightly different axis, in order to suggest that when the two lines overlap (i.e., when Treasury yields are 1 percentage point higher than core inflation), then 5-yr Treasuries are at "fair value," since they offer investors a modest real return—which is appropriate for a relatively short-term, risk-free asset. Treasuries offered excellent value in the 80s and 90s, and fair value from 2008 through early last year. Since April of last year, however, they have moved decisively into "undervalued" territory, as yields have sharply diverged from core inflation (in the wrong way) for the first time in modern memory. We are living in unprecedented times, with core inflation moving higher while Treasury yields fall to record lows. And it's not that yields are low because the market fears deflation, since the expected inflation embedded in TIPS and Treasury prices is within the range of 2-2.5%.

The explanation for why Treasury yields were high relative to inflation in the 1980s and 1990s is simple: monetary policy was generally tight from 1979 through 2002. When the Fed is tight, the market expects the Fed to react promptly to changes in the economy's growth and inflation fundamentals, and to have a bias to keeping rates higher than inflation in order to prevent strong growth from becoming inflationary.

The explanation for what's going on now is a bit more complicated. For some time now, the Fed has been working hard to convince the market that it is willing to sacrifice higher inflation in exchange for stronger growth, by keeping interest rates very low relative to inflation, and for a very long time. The prospect of many years of near-zero short-term rates almost forces investors to move out the yield curve in order to pick up incremental yield. Beginning last summer, fears of sovereign debt defaults among the PIIGS countries began to create intense demand for dollar-denominated safe-haven assets (with short- and intermediate-term Treasuries being the prime candidate), and foreign buying of Treasuries has dovetailed nicely with the Fed's desire to make interest rates as low as possible across the yield curve.

But: Can very low Treasury yields that are also low or negative in real terms really be a prescription for more real growth? And how much longer can yields remain so far below inflation?

Treasury yields form the backbone of the global bond market, since almost all bonds are priced off of comparable maturity Treasuries. Thus, very low Treasury yields tend to result in very low yields on other sovereign bonds, on corporate bonds, and on mortgage-backed securities. And indeed, today the yield on the average investment grade corporate bond is 4.3%, which is very near its lowest level ever, and substantially less than the average yield of 5.5% over the past 5 years. Similarly, the yield on current coupon MBS is now at an all-time low of 2.6%, and is significantly less than the average yield of 4.6% over the past 5 years. Junk bond yields currently average 7.9%, which is lower than the 10.4% average of the past 5 years, but about the same as what we saw in 2004 and 2011, when yields also averaged 7.9%. So there's a caveat here: record-low Treasury have not resulted in record-low borrowing costs for everyone—only high-quality borrowers are getting an unusual break these days.

In any event, today's low yields don't necessarily translate into a growth stimulus, because they are the by-product of weak growth and dismal growth expectations. If the world had high expectations for future growth, investors would simply not be paying such a high price for Treasuries. To date, investors have been content to buy Treasuries at absurdly low yields because they perceive that they have few alternatives to Treasuries on a risk-adjusted basis. They are so worried about future growth and the possibility of default on non-Treasuries that they are willing to accept a negative real yield on Treasuries.

Therefore, growth—even the modest growth that we have seen during this tepid recovery—ultimately presents the biggest threat to the Treasury market. The more time that passes without a calamity, the more upward pressure there will be on Treasury yields, since the rationale for their purchase—to avoid a calamity—will be slowly evaporating.